How to Withdraw Money From Your 401(k) Early

It can be done, but do it only as a last resort

A 401(k) plan is an employer-sponsored retirement savings plan with tax advantages for both the employee and the employer. The money accumulated in the account is allowed to grow tax-free over the years. The goal is to wait until retirement to begin withdrawing the money.

It's possible to get money out of the account before age 59 1/2 if you need to. But with a few exceptions, the account holder will be hit with a substantial income tax bill plus a 10% penalty.

And, that early withdrawal will deplete their retirement savings permanently.

There are other options you may consider before making an early 401(k) withdrawal. And if you must make the withdrawal, there are ways to reduce the financial pain.

Key Takeaways

  • Taking an early withdrawal from your 401(k) should only be done only as a last resort.
  • If you are under age 59½, in most cases you will incur a 10% early withdrawal penalty and owe regular income taxes on the amount taken out.
  • Under certain limited circumstances, a withdrawal without penalty is permitted, but income taxes will still be due on the withdrawal.
  • A better option may be to take out a loan from your 401(k) and repay it over time with a payroll deduction.

Understanding Early Withdrawal From a 401(k)

Withdrawing money early from your 401(k) can carry serious financial penalties, so the decision should not be made lightly. It really should be a last resort.

Not every employer allows early 401(k) withdrawals, so the first thing you need to do is check with your human resources department to see if the option is available to you.

As of 2021, if you are under the age of 59½, a withdrawal from a 401(k) is subject to a 10% early withdrawal penalty. You will also be required to pay regular income taxes on the withdrawn funds.

For a $10,000 withdrawal, when all taxes and penalties are paid, you will only receive approximately $6,300. 

The Hardship Withdrawal

The IRS permits withdrawals without a penalty for "immediate and heavy financial needs."

Don't guess. Check the current IRS rules to see whether your reason for withdrawing money is likely to be deemed a hardship withdrawal.

You may also withdraw up to $5,000 without penalty to pay expenses related to the birth or adoption of a child under the terms of the SECURE Act of 2019.

And keep in mind that you'll still owe income taxes on that money. If it is a traditional IRA, you'll owe taxes on the entire withdrawal. If it is a Roth IRA, you'll owe taxes only on the profits that accumulate in the account because you've paid in after-tax money.

There is currently one more permissible hardship withdrawal, and that is for costs directly related to the COVID-19 pandemic.

Exceptions to the Penalty

The IRS permits withdrawals without a penalty for certain specific uses. These include a down payment on a first home, qualified educational expenses, and medical bills, among other costs.

As with the hardship withdrawal, you will still owe the income taxes on that money, but you won't owe a penalty.

$6,300

The approximate amount you will clear on a $10,000 withdrawal from a 401(k) if you are under age 59½ and subject to a 10% penalty and taxes.

The COVID-19 Exception

The CARES Act allowed individuals affected by the coronavirus pandemic to take a distribution of up to $100,000 from a 401(k) account, provided their employers adopted the distribution rules of the act.

Not only did the act waive the 10% tax penalty on such distributions, but it also allows anyone who takes a distribution to pay the taxes due on it over a three-year period.

In addition, if you repay the distribution in part or in full within three years, you can recoup the taxes you paid on it by filing amended federal tax returns.

How to Make an Early Withdrawal from a 401(k)

When you have determined your eligibility and the type of withdrawal you want to make, you will need to fill out the necessary paperwork and provide the requested documents. The paperwork and documents will vary depending on your employer and the reason for the withdrawal, but when all the paperwork has been submitted, you will receive a check for the requested funds, hopefully without having to pay the 10% penalty.

Borrowing From a 401(k)

Generally, it's better to take a 401(k) loan than to make an early withdrawal. Essentially, you're loaning money to yourself, with a commitment to paying it back.

Instead of losing a portion of your investment account forever—as you would with a withdrawal—a loan allows you to replace the money, which you can do through payments deducted from your paycheck.

You’ll have to check if your plan offers loans, as well as if you’re eligible.

You might also consider obtaining a personal loan elsewhere, such as through a bank.

If your only option is a 401(k) withdrawal, avoid the 10% penalty by making sure that your withdrawal qualifies with the IRS as a hardship or an exception.

Substantially Equal Periodic Payments (SEPP)

Substantially equal periodic payments (SEPPs) are another option for withdrawing funds without paying the early distribution penalty if the funds are in an Individual Retirement Account (IRA) rather than a company-sponsored 401(k) account.

SEPP withdrawals are not permitted under a qualified retirement plan if you are still working for your employer. However, if the funds are coming from an IRA, you may start SEPP withdrawals at any time.

SEPP withdrawals are not the best idea if your financial need is short-term. When starting SEPP payments, you must continue for a minimum of five years or until you reach the age of 59½, whichever comes later. Otherwise, the 10% early penalty still applies, and you will owe interest on the deferred penalties from prior tax years.

There is an exception to this rule for taxpayers who die (for beneficiary withdrawals) or become permanently disabled.

SEPP must be calculated using one of three methods approved by the Internal Revenue Service (IRS): fixed amortization, fixed annuitization, or required minimum distribution (RMD). Each method will calculate different withdrawal amounts, so choose the one that is best for your financial needs.

Can You Withdraw Money From a 401(k) Early?

Yes, if your employer allows it.

However, there are financial consequences for doing so.

You also will owe a 10% tax penalty on the amount you withdraw, except in special cases:

  • If it qualifies as a hardship withdrawal under IRS rules
  • If it qualifies as an exception to the penalty under IRS rules
  • If you need it for COVID-19-related costs

In any case, the person making the early withdrawal will owe regular income taxes year on the money withdrawn. If it's a traditional IRA, the entire balance is taxable. If it's a Roth IRA, any money withdrawn early that has not already been taxed will be taxed. (The taxes are due on the profits that the account accrued but not on the money you paid in, which has already been taxed.)

If the money does not qualify for any of these exceptions, the taxpayer will owe an additional 10% penalty on the money withdrawn.


What Are the Penalty-Free Exceptions for an Early IRA Withdrawal?

The IRS permits withdrawals without a penalty for certain specific uses, including to cover college tuition and to pay the down payment on a first home. It terms these "exceptions," but they also are exemptions from the penalty it imposes on most early withdrawals.

It also allows hardship withdrawals to cover an immediate and pressing need.

There is currently one more permissible hardship withdrawal, and that is for costs directly related to the COVID-19 pandemic.

You'll still owe regular income taxes on the money withdrawn but you won't get slapped with the 10% early withdrawal penalty.

How Much Tax Do I Pay on an Early 401(k) Withdrawal?

The money will be taxed as regular income. That's between 10% and 37% depending on your total taxable income.

In most cases, that money will be due for the tax year in which you take the distribution.

The exception is for withdrawals taken for expenses related to the coronavirus pandemic. In response to the coronavirus pandemic, account owners have been given three years to pay the taxes they owe on distributions taken for economic hardships related to COVID-19.

What Are the Pros and Cons of Withdrawal vs. a 401(k) Loan?

A withdrawal is a permanent hit to your retirement savings. By pulling out money early, you’ll miss out on the long-term growth that a larger sum of money in your 401(k) would have yielded.

Though you won’t have to pay the money back, you will have to pay the income taxes due, along with a 10% penalty if the money does not meet the IRS rules for a hardship or an exception.

A loan against your 401(k) has to be paid back. If it is paid back in a timely manner, you at least won’t lose much of that long-term growth in your retirement account.

Article Sources

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